Western Alliance Bancorporation (NYSE:WAL) Q3 2023 Earnings Call Transcript

Western Alliance Bancorporation (NYSE:WAL) Q3 2023 Earnings Call Transcript October 20, 2023

Operator: Good day, everyone. Welcome to Western Alliance Bancorporation’s Third Quarter 2023 Earnings Call. You may also view the presentation today via webcast through the company’s website at www.westernalliancebancorp.com. I’d now like to turn the call over to Miles Pondelik, Director of Investor Relations and Corporate Development. Please go ahead.

Miles Pondelik: Thank you. Welcome to Western Alliance Bank’s third quarter 2023 conference call. Our speakers today are Ken Vecchione, President and Chief Executive Officer; Dale Gibbons, Chief Financial Officer; and Tim Bruckner, our Chief Credit Officer, will join for Q&A. Before I hand the call over to Ken, please note that today’s presentation contains forward-looking statements, which are subject to risks, uncertainties and assumptions, except as required by law, the company does not undertake any obligation to update any forward-looking statements. For a more complete discussion of the risks and uncertainties that could cause actual results to differ materially from any forward-looking statements, please refer to the company’s SEC filings, including the Form 8-K filed yesterday, which are available on the company’s website. Now for opening remarks, I’d like to turn the call all over to Ken Vecchione.

Kenneth Vecchione: Thank you, Miles. Good morning, everyone. I’ll make some brief comments about our third quarter 2023 results, and then I’ll turn the call over to Dale. One year ago, on our Q3 2022 call, we discussed our plans to temper balance sheet growth to bolster capital and liquidity in order to reinforce our financial foundation and position the bank to navigate through a volatile rate environment. The events of the spring caused by duration mismatch at several regional banks validated the importance of our strategy and accelerated its implementation through surgical balance sheet repositioning. The recalibration of our business model to enhance overall liquidity and deposit granularity is designed to make the balance sheet unassailable in the event of another significant market disruption.

As a result, our CET1 capital has grown from 8.7% a year ago to 10.6% today. Our HFI loan-to-deposit ratio has improved from 94% to 91%. To provide enhanced protection to depositors and cement the stability of our deposit base, insured and collateralized deposits have risen from 47% at year-end to 82%. In order to fortify our liquidity position, we have materially increased our cash and investment securities and now have $3.2 billion of high-quality liquid asset treasures. Having established strong capital, liquidity and deposit granularity, a sturdy foundation has been laid to deliver earnings improvement going forward. Over the last several quarters, we have prioritized stabilizing and growing deposits as well as optimizing the liability structure by paying down borrowings.

This has led to net interest margin growing from our second quarter trough as we have sustained improvement in our funding structure, lowered our adjusted efficiency and produced above-peer return on average assets and return on average tangible common equity. Over the next one to two quarters, we will complete the optimization of our funding structure and be well positioned to deploy excess core deposits into loan growth. In the third quarter, Western Alliance profitability, strong liquidity generation and stable asset quality are proof points to the dexterity of our diversified business model. Before handing the call over to Dale, I want to highlight the drivers of our strong deposit growth in Q3. Core commercial clients, both new and existing, were the primary sources contributing to $3.1 billion of growth.

Mortgage warehouse and HOA pushed growth upward and the regional network posted a second consecutive quarter of vigorous deposit contributions. Overall, deposit cost increased 27 basis points. The overall cost of interest-bearing liabilities compressed 5 basis points to 2.8% in Q3 as we utilized deposits to pay down higher-cost borrowings, which Dale will comment on later. Liquidity came in ratably over the quarter to push down our average borrowings. Core commercial deposits cost a marginal 4.04%, including cost of earnings credit rates. Cultivating multiproduct customer relationships remains critical for solidifying and growing client relationships, which is held in the mid-80% range in recent quarters. Our digital consumer channel, a source of liquidity uncorrelated with our core commercial business lines, generated approximately $800 million this quarter at attractive rates relative to the module cost of repay borrowings.

In short, I feel confident in the vitality of our deposit franchise and how it sets up for future success. Now, Dale will take you through our financial performance. Dale Gibbons Thanks, Ken. For the quarter, Western Alliance generated net income of $217 million, EPS of $1.97 and pre-provision net revenue of $290 million. Net interest income increased $37 million during the quarter to $587 million from favorable repricing of earning assets, as well as a reduction in higher-cost borrowings. Non-interest income increased $10 million to $129 million, which included approximately $6.5 million of non-recurring pretax items such as fair value adjustment. AmeriHome was moderately impacted by rising mortgage rates and treasury yields with mortgage banking revenue declining $7 million to $79 million as lot volume fell 5% quarter-over-quarter and production margins compressed slightly to 38 basis points.

Non-interest expense growth was primarily driven by higher deposit costs and software licensing and depreciation expenses. Deposit cost of $128 million demonstrated our deposit share gains from new customers and previous clients returning funds to the grant. Provision expense was $12 million due to stable asset quality and loan growth concentrated in low-loss categories. Our provision modeling remains conservative given the weighting of the Moody’s consensus forecast into barely adverse scenarios, which in aggregate, implies an 80% probability of recession. Lastly, our tax rate rose because of discrete non-deductible items in the quarter. We expect our tax rate to fall back to between 20% and 21% going forward. Overall, we made substantial progress in increasing on balance sheet liquidity with investments in cash 19% higher quarter-over-quarter, mostly from adding more high-quality liquid assets.

Deposit share gains and balance sheet remixing also pushed wholesale borrowings lower. Cash and cash equivalents alone totaled $3.5 billion, up from $2.2 billion last quarter. With our strong deposit growth and capital levels, we elected to reclassify $1.3 billion of non-AmeriHome held-for-sale loans back to held for investment as organic loan growth has slowed. These transferred loans are short duration, low credit risk assets, which we believe are better served generating interest income for the bank going forward. The remaining loans held for sale consist entirely of AmeriHome residential inventory to be sold to the GSEs and have an average duration of only about two weeks, including $1.3 billion of loans transferred from held for sale, loans held for investment rose $1.6 billion to $49.4 billion.

As Ken mentioned, deposits increased $3.2 billion to $54 billion at quarter end. Mortgage servicing rights increased in part due to the higher rate environment and stood at $1.2 billion on September 30. Total borrowings declined by $820 million to $9.6 billion at quarter end, but average borrowings declined nearly $6 billion quarter-over-quarter, primarily from the repayment of Federal Home Loan Bank borrowings and private equity lines obtained for March earlier this year. Organic held for investment loans grew $240 million, primarily from C&I, and centered around mortgage warehouse, MSR financing, and corporate finance, with smaller contributions for our regional banking. HFI construction and land loan growth of $241 million, derived mostly from lot banking loans reclassified from held-for-sale status.

Given the national undersupply of homes, we still view the macro backdrop for this product favorably despite the elevated rate environment. Total deposit growth of $3.2 billion resulted primarily from an increase in core deposits and also reflects a reduction in wholesale broker deposits of over $400 million. Core deposit growth was fueled by $1.3 billion in non-interest-bearing DDA growth led by Mortgage Warehouse and $1.6 billion in savings and money market growth. Non-interest-bearing DDA comprised a third of our total deposits, of which approximately 40% have no cash payment or earnings credits. Quarter-to-date, deposit growth has surpassed $3 billion, though semi-annual seasonality of mortgage warehouse deposits and tax and insurance escrow funds will pull this number down as payments are made this quarter.

Turning now to debt interest drivers. Favorable repricing in a higher rate environment increased the yield on earning assets, optimization of the liability structure by growing deposits to pay down short-term borrowings led to a lower cost of funding — liability funding. The securities portfolio grew $1 billion to $11.4 billion as we prioritized adding HQLA to the balance sheet. The yield on total investments expanded 15 basis points to 4.91%. $1.8 billion in securities yielded 4.77% are also expected to mature by year-end, with another $2 billion yielding 4.98%, maturing in 2024. Similarly, HFI loans increased 25 basis points to 6.73% with a quarter-end spot rate of 6.99%. In a higher prolonged rate environment, we expect to benefit from favorable asset pricing tailwinds.

Total fixed convertible loan maturities are expected to average $2.4 billion per quarter for the first three quarters of 2024. Our strategy to rightsize the liability funding structure through increased savings and money market accounts resulted in a 41 basis point increase in the cost of interest-bearing deposits. Importantly, this enables a $5.9 billion reduction in average short-term borrowings to 14% of interest-bearing liabilities, which resulted in a 5 basis point reduction in the overall cost of interest-bearing liabilities to 2.8% in the third quarter. As noted on our last earnings call, we believe net interest income and net interest margin reached a cycle trough in the second quarter. Net interest income grew nearly 7% despite a modest contraction in average earning assets and as the margin expanded 25 basis points quarter-over-quarter to 3.67%.

Considering the impact of future rate changes, our rate risk profile is modestly asset-sensitive. Our plus 100 basis point rate shock analysis on a static balance sheet indicates net interest income is expected to lift approximately 4% and increase a similar amount on a minus 100 basis points shock. However, considering a more comprehensive review of interest rate risk, we project a 2.2% increase in earnings at risk from a 100 basis point negative shock on a static balance sheet, which is inclusive of estimated declines in ECR-related deposit costs. Additionally, in a lower rate environment, mortgage banking acts as a shock absorber to our asset-sensitive balance sheet from increased refinancing activity and gain on sale margin expansion. Our efficiency ratio of 58.8% was 170 basis points higher than in Q2, though our adjusted efficiency ratio, excluding the impact of ECRs, fell 50 basis points to 50% as mortgage warehouse average balances with ECRs increased $2.4 billion to $11 billion in the third quarter.

Lower compensation expenses resulted from normal seasonal factors and mitigated — and mitigated higher software licensing and data processing costs. We still view a mid to upper 40% efficiency ratio as indicative of the right medium-term level of investments to fund new business initiatives and the ongoing evolution of our risk management framework. Pre-provision net revenue was $290 million for the quarter. Solid profitability was maintained in Q3 with a stable return on average assets of 1.24% on a larger balance sheet. Return on average tangible common equity of 17.3% was modestly below our Q2 level as our capital level time. Our proactive credit mitigation strategy has been effective thus far in normalizing credit environment. Asset quality was stable in Q3 as the aggregate net increase in special mention loans and classified assets was only $9 million.

Notably, nonperforming assets declined $22 million to $245 million or to 35 basis points of total assets. Quarterly, net loan charge-offs were $8 million or 7 basis points of average loans compared to $7.4 million or 6 basis points in the second quarter due to growth in low to no loss categories in conjunction with stable asset quality led to a smaller provision expense even in a normalizing credit environment. Our total funded ACL increased $6 million from the prior quarter to $327 million as HFI growth occurred almost entirely in near zero loss categories, both prominently in mortgage warehouse. As a reminder, even after repaying two credit linked notes, 22% of our loan portfolio was still protected with any losses incurred to be covered by a third party.

The total loan ACL to funded loans ticked down 2 basis points to 74 basis points, but did increase 13 basis points to 154% of nonperforming loans. We view our allowance as appropriate, especially when considering the material portion of loans covered by first loss credit protection from credit-linked notes and low loss loan categories. Additionally, a sizable portion of our loan growth has been concentrated in low to no loss products. Our loan portfolio is diversified across risk segments with almost a quarter of that are either credit protected, government guaranteed or cash secured and over half of the portfolio is either insured or resistant to economic volatility. If adjusted for these factors, our ACL rates rises to 1.34% of loans. Our strong organic capital growth lifted the CET1 ratio of the 10.6% [indiscernible] 6.8% when adjusted for AOCI and tax-affected unrealized held-to-maturity securities marks.

Our tangible common equity to total assets decreased approximately 20 basis points from Q2 to 6.8% as the balance sheet expanded modestly, while capital growth was curtailed by our higher AOCI mark. Given the 45 basis point rise in the five year treasury during the quarter, AOCI reached use tangible common equity by $732 million. Inclusive of our quarterly cash dividend payment of $0.36 per share, our tangible book value per share increased $0.57 in the quarter to $43.66. The quarter-over-quarter increase resulted from our earnings outpacing industry-wide AOCI headwinds, setting for rising rates. I’ll now turn the call back to Ken. Kenneth Vecchione Thanks, Dale. Our guidance for the rest of 2023 continues to be informed by the strategies and priorities laid out in our prior earnings call.

So as we look forward to Q4, you can expect loans and core deposits are expected to be fairly flat to several hundred million dollars higher in Q4. Net deposit growth will be impacted by normal Q4 seasonal reductions in mortgage warehouse deposits, offset by growth in the regional divisions and the digital consumer channel. Deposits should still outpace loan growth. Going into 2024, we expect loan and deposit growth to return to our prior guidance. Regarding capital, having closed the 40 basis points of our medium-term CET1 target of 11%, we forecast continued although more gradual progress towards this goal, which we remain on track to achieve in 2024. Net interest margin should remain in line with our Q3 level in a range of 3.60% to 3.70%, supported by asset pricing tailwinds and additional if more tempered borrowing repayment opportunities.

Our adjusted efficiency ratio, which excludes the impact of deposit costs, should remain consistent with Q3 levels. Regarding operating PPNR, we expect Q4 to be generally consistent with Q3, excluding the onetime items noted and acknowledging that mortgage banking revenue will be influenced by the impact of the rate environment on mortgage gain on sale. Asset quality remains manageable, projects continue to be supported by sponsors based on our conservative underwriting and low advance rates, credit losses are still expected to be 5 basis points to 15 basis points through this economic cycle. At this time, Dale, Tim and I are happy to take your calls — question, sorry.

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Q&A Session

Operator: Thank you. [Operator Instructions] Our first question comes from Casey Haire of Jefferies. Casey, your line is open. Please go ahead.

Casey Haire: Yes. Great. Thanks. Good morning. everyone. Maybe first question on the NIM. Can you just walk us through — just walk us through, I guess, what the NIM guide presumes in the way of borrowings. Obviously, your deposit growth, very strong quarter-to-date. I think, Ken, you mentioned you do expect that to pay down. And so just — that would bring the borrowings, which were up pretty significantly period end versus the average in 3Q. Just wondering where that would end up in the fourth quarter here.

Dale Gibbons: Yes. So we have some seasonality within deposit categories that affect this number. But the direction of borrowings is going to continue to be down. So we paid off several of our more expensive funding sources that we achieved or acquired late in the first quarter. And there’s a little bit left, I expect we’re to pay down that amount as well. So we should continue to see kind of improvement there, where you see we are in terms of reasonably balanced on target for loan to deposit growth this quarter, I think you should see some kind of modest improvement in ending balances as well. And I think the average balances should improve somewhat as well, but not to the degree they did in the third quarter, I would expect.

Kenneth Vecchione: Yes, Casey, as you’ve seen, we took down our short-term borrowings by $870 million. But any time we have any excess liquidity floating around, we use it to pay down borrowings. So average borrowings declined $6 billion in the quarter, and that helped bring down our lower funding rate.

Casey Haire: Okay. Great. And just, Dale, I wanted to follow up on your comments on the fixed rate asset repricing benefit in the first three quarters of 2024. I think you said $2.4 billion per quarter. Can you give us a sense of where — like what the blended yield is on that and what that can repriced to? Just trying to quantify what the repricing benefit could be.

Dale Gibbons: So, in terms of what the repricing could be, these are coming off at something in the kind of around the higher seven and rates today have spreads of really not less than 300 basis points, 350 from there. And so maybe you don’t have another rate increase in there, so I would take that on top of SOFR today. So something in the lower eight.

Casey Haire: Okay. So over $7 billion of loans in the first three quarters with 100 bps left.

Dale Gibbons: Approximately.

Casey Haire: Okay. All right. Just last one for me on the expenses. Obviously, that was the one thing that kind of surprised negatively this quarter on the deposit cost. So if — so I have — the deposit with ECR. The DDA with ECR up 15%, but the deposit costs were up 40%. So I’m just trying — like why the disconnect? What was the — is there a different pricing dynamic today than there was historically? Just trying to understand that.

Dale Gibbons: Well, we had higher balances and higher rates and I think the average balance was elevated. The average balance was up 28% during the quarter. So it wasn’t — let me approach it differently. In terms of the spreads that these clients receive, there’s virtually no change.

Casey Haire: Okay. So — all right. So we don’t have the average balances. It’s just at period end was up 15%. The averages was up higher. And then just [indiscernible] as well.

Dale Gibbons: 28%, almost double that. Yes.

Casey Haire: Okay. Great. Thank you.

Operator: Our next question comes from Steven Alexopoulos of JPMorgan. Steven, your line is open. Please go ahead.

Steven Alexopoulos: Hi, everybody. I want to start, regarding getting back to the $500 million per quarter loan growth target at $2 billion deposit growth in 2024. Once you guys get to the mid-80% loan-to-deposit ratio target, what’s more likely that you guys dial up the loan growth expectation at that point or that you dial down the deposit growth?

Dale Gibbons: You’ll see on the asset side, you’ll see that, that will be the lever that will be used.

Steven Alexopoulos: Okay. So you’re thinking keep the $2 billion deposit target intact and then dial up expectations for asset growth?

Kenneth Vecchione: Yes. This is Ken. I think so. I think some of the investments that we’ve made in a number of our deposits centric business lines will continue to propel deposits forward along the guide that we gave. And as we recalibrate to a mid-80s loan-to-deposit ratio, we’ll then turn off the loan growth machine. We’ve proven here over time that we can generate sound, thoughtful, reasonable loan growth with very little asset quality problems.

Steven Alexopoulos: Got it. Okay. And then going back to Casey’s question on expenses. Excluding the ECR-related deposit costs, which flow through at those sites, how are you guys thinking about expense growth over the next year?